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Preparation of Capital Budget: 4 Main Steps

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This article throws light upon the four main steps involved in the preparation of capital budget of a firm. The steps are: 1. Origination of Investment Proposals 2. Investigation of Investment Proposals by Budget Committee 3. Final Decision of Projects 4. Allocation of Funds.

Preparation of Capital Budget: Step # 1.

Origination of Investment Proposals:

The capital budgeting process begins with the assembling of investment proposals of different departments of the enterprise. Each departmental head will determine the various possible capital expenditures that he believes are necessary or worthwhile. He may have a number of alternate projects available to meet a given need.

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These projects are conflicting proposals because they are mutually exclusive, i.e., if one is accepted, the other cannot be adopted. Examples are the consideration of two machines designed to perform the same function. The selection of one alternative automatically rules out the selection of the other.

The departmental head must select the best alternative from among the conflicting proposals for submission to the budget committee. This selection is made after estimating return on the projects and comparing the same with the cost of capital. Investment proposal which gives highest net marginal return will be the obvious choice.

Preparation of Capital Budget: Step # 2.

Investigation of Investment Proposals by Budget Committee:

When departmental heads submit projects of their departments to the budget committee for consideration, these are then scrutinized in detail by the committee. Projects are evaluated on the basis of standards laid down from time to time by the firm. More often than not, the proposals submitted by different departments may turn out to be conflicting.

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For example, the personnel manager may submit a plan for building employee’s parking on a site presently lying unused. The manager, research and development department may request for a new laboratory on the same plot. The task of the budget committee is to determine which proposal should be accorded priority.

Next task of the budget committee is to evaluate competing proposals from economic and other points of view and choose the most useful proposal. Unlike conflicting proposals, competing proposals do not conflict with each other but these are not equally desirable.

With the limited resources in hand a firm cannot carry out all such projects. In view of this, the budget committee has to evaluate economic viability of all the projects in hand and select the most deserving one.

Economic desirability of projects is studied in context of their estimated cash inflows and outflows and cost of capital of the firm. Projects are also evaluated from non-economic points of view. Sometimes, it is observed that a proposal is economically desirable, the new machine may be found more lucrative than the research facilities but the management believes that for boosting general morale and status of employees it will be useful to have the laboratory.

Preparation of Capital Budget: Step # 3.

Final Decision of Projects:

After evaluating investment proposals from different considerations, the budget committee submits its own recommendations in detail about the projects to the Board of Directors. The Board usually consults the finance manager before taking the final decision on the projects.

Preparation of Capital Budget: Step # 4.

Allocation of Funds:

The Board of Directors communicates its decision on investment proposals to the finance manager. The latter is also informed about the total funds that will have to be arranged for financing the selected projects. On receiving the information, the finance manager begins his task of arranging capital from different sources.